DOES THE CLARITY OF CENTRAL BANK COMMUNICATION AFFECT VOLATILITY IN FINANCIAL MARKETS? EVIDENCE FROM HUMPHREY-HAWKINS TESTIMONIES

Abstract

I. INTRODUCTION This article investigates whether greater clarity of central bank coincides with lower levels of volatility in financial Recent empirical work has established that central bank talk is often an important source of information for the private sector. Surveying the literature, Blinder et al. (2008) conclude that communication can be an important and powerful part of the central bank's toolkit since it has the ability to move financial markets. Still, it is not clear what would constitute an optimal strategy. In practice, large differences exist in the way in which central banks communicate. Some central banks, such as the Federal Reserve and the Bank of England, publish detailed minutes of their monetary policy meetings, whereas others, such as the European Central Bank, do not. At the same time, the European Central Bank is one of the few central banks holding an elaborate press conference shortly after the interest rate decision. Finally, some central banks, such as the Reserve Bank of New Zealand and Norges Bank, publish forecasts of their own policy rate, whereas most monetary authorities refrain from doing so. Alongside the issue of optimal communication, there has been a long-standing debate on central bank A greater degree of transparency may have important benefits, such as well-anchored inflation expectations. At the same time, various authors have suggested that limits to transparency may exist (Cukierman and Meltzer 1986, Morris and Shin 2002). Whether transparency is and to what extent, is in the end an empirical matter. evidence in favor of transparency has accumulated over the years. Although Geraats (2002) cautiously concluded that the available evidence suggests that transparency tends to be beneficial, more recently, van der Cruijsen and Eijffinger (2007) find that The empirical results are largely in favor of more transparency. Many studies in the literature use measures of institutional transparency, such as whether the central bank publishes macroeconomic forecasts or information on its policy deliberations. So far, the clarity of actual central bank communications has received little attention. (1) Still, if the central bank communicates regularly, but does so in a nonaccessible manner, it can hardly be called transparent. Moreover, the relationship between clarity and volatility seems intuitive: when central bankers communicate clearly, financial markets have less difficulty in interpreting the central bank's message. This leads to less uncertainty, which is reflected in lower levels of volatility. Therefore, this article contributes to the literature by focusing on the effects of clarity of communication. For a broad range of financial instruments, it is tested whether clarity of affects volatility. Two readability statistics are used--the Flesch reading ease score and the Flesch-Kincaid grade level--to measure the clarity of central bank communication. Both statistics have been widely applied in other fields. (2) One benefit of these two criteria is their objectivity: they are completely based on the characteristics of the underlying texts. Readability statistics are applied to the testimony by the Chairman of the Federal Reserve at Congressional Monetary Policy Oversight hearings--more commonly known as the Humphrey-Hawkins hearings. For almost 30 years these testimonies have been one of the main channels of the Federal Reserve. This article has three key results. First, when clarity matters, the results point to the conclusion that clarity diminishes volatility. Second, clarity of matters mostly for volatility of medium-term interest rates. Third, the effects of clarity vary over time. There is an indication that clarity has especially mattered during Alan Greenspan's term at the Federal Reserve. Overall, the analysis shows the importance of transparent on monetary policy. …